THE COLLAPSE OF DEPOSIT INSURANCE — AND THE CASE FOR ABOLITION By Richard M. Salsman ECONOMIC EDUCATION BULLETIN Published by AMERICAN INSTITUTE FOR ECONOMIC RESEARCH Great Barrington, Massachusetts Copyright Richard M. Salsman 1993 About A.I.E.R. MERICAN Institute for Economic Research, founded in 1933, is an independent scientific and educational organization. The A Institute's research is planned to help individuals protect their personal interests and those of the Nation. Tìie industrious and thrifty, those who pay most of the Nation's taxes, must be the principal guardians of American civilization. By publishing the results of scientific inquiry, carried on with diligence, independence, and integrity, American Institute for Economic Research hopes to help those citizens preserve the best of the Nation's heritage and choose wisely the policies that will determine the Nation's future. The Institute represents no fund, concentration of wealth, or other special interests. 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You can receive ABER's twice monthly Research Reports and monthly Economic Education Bulletin by entering a Sustaining Membership for only $16 quarterly or $59 annually. If you wish to receive only the Economic Education Bulletin, you may enter an Education Membership for $25 annually. ECONOMIC EDUCATION BULLETIN Vol. XXXIII No. 9 September 1993 Economic Education Bulletin (ISSN 0424-2769) (USPS 167-360) is published once a month at Great Barrington, Massachusetts, by American Institute for Economic Research, a scientific and educational organization with no stockholders, chartered under Chapter 180 of the General Laws of Massachusetts. Second class postage paid at Great Barrington, Massachusetts. Printed in the United States of America. Subscription: $25 per year. POSTMASTER: Send address changes to Economic Education Bulletin, American Insti- tute for Economic Research, Great Barrington, Massachusetts 01230. Contents I. Introduction 1 The Nature of the Collapse 2 II. The Shaky Origins of Federal Deposit Insurance 3 Early Experiments at the State Level 3 The Movement Toward Federal Insurance 7 Some Technical Objections 9 A Guaranty System 10 III. Why Deposit Insurance Undermines Sound Banking 13 Breaking the Banks 14 Winners and Losers 16 Didn't Deposit Insurance Work for 50 Years? 17 Myths About Free Banking 19 The Nationalization of Credit 21 IV. Some Futile Reforms of a Flawed System 22 Tighter Regulation? 22 Fingers in the Dike 24 V. Abolishing Deposit Insurance 28 Conclusion 29 Bibliography 30 About the Author Richard M. Salsman is a vice president and economist at H. C. Wain- wright & Co. Economics, Inc., an economic forecasting and investment advisory firm based in Boston. Prior to joining Wainwright, he worked for 12 years in the commercial banking industry, at Manufacturers Hanover, The Bank of New York, and Citibank. Mr. Salsman is also an adjunct fellow at the American Institute for Economic Research, a member of the American Economic Association, and a member of the Board of the Committee for Monetary Research and Education. Mr. Salsman is author of Breaking the Banks: Central Banking Prob- lems and Free Banking Solutions (Great Barrington, MA: American Insti- tute for Economic Research, 1990). He has also authored "Why We Need Free Banking" (AIER Research Reports, June 4, 1990), "The Credit Crunch: Myth or Reality?" (AIER Research Reports, December 2, 1991 and December 16, 1991), "Banking Without the Too-Big-To-Fail' Doc- trine" {The Freeman, November 1992), "Can Fiat Money Be Effectively Managed?" (AIER Research Reports, June 7,1993), and a chapter, "Bank- ers as Scapegoats for Government-Created Banking Crises in U.S. His- tory," in The Crisis in American Banking (New York University Press, 1993). Mr. Salsman received his B.A. in Law and Economics from Bowdoin College in 1981 and his M.B.A. in Economics from New York University Graduate School of Business in 1988. He received the designation of Chartered Financial Analyst from the Association for Investment Manage- ment and Research in 1993. I. INTRODUCTION HE American system of Federal deposit insurance has collapsed under the weight of its internal contradictions and perverted incen- T tives. Left in its wake is a degree of wealth destruction unparalleled in banking history — reckless lending, wasted capital, widespread bank failures, depleted reserve funds, political corruption, and taxpayer bailouts. Reformers who are groping for solutions to the American banking crisis face a stark choice. They can continue attaching patchwork "life support" systems to the fatally flawed corpse known as deposit insurance, or they can let the system collapse under the weight of its contradictions, thereby permitting safe and sound banking to flourish once again. The regenerative power of the American banking system is great — but it can only emerge in an atmosphere free of the deadening hand of deposit insurance. The purpose of this booklet is to provide lawmakers and the public an explanation of why Federal deposit insurance has collapsed, why it has undermined sound banking, why it has strained government finances, and what can be done about it. The diagnosis presented, though grim, is realistic. The fundamental nature of the solution — complete abolition of deposit insurance — reflects the seriousness of the diagnosis. No case for abolishing deposit insurance should be made lightly. But the facts warrant nothing less than complete abolition. Contrary to conventional wisdom, Federal deposit insurance is a fatally flawed system that never worked and cannot be made to work. Recent attempts to incorporate "market oriented" features into what is essentially a socialistic system, while laudable, do not go far enough. They are merely half-hearted attempts to do the right thing, to establish a truly market- based banking system. We can appreciate that the superiority of the market is conceded. But there is no case for going half-way by mixing markets in with statism. Mere tinkering or reform of a fatally flawed system simply will not do. Quick fixes of deposit insurance will only postpone its inevi- table demise, further intensifying weaknesses in the banking industry, and further inflating the government's ballooning financial obligations. The crisis in American banking and the collapse of deposit insurance were virtually ignored by President Clinton during his campaign. But in the spirit of its campaign's slogan, "Putting People First," the Clinton administration should be candid with the American people. The electorate deserve to know the extent of the crisis and to benefit by fundamental solutions. This approach, if adopted, would mark the arrival of genuine change in Washington. 1 The Nature of the Collapse After 50 years of seemingly unblemished success, the past decade has seen the complete collapse of the deposit insurance system in the United States. The government deposit insurance funds for both the thrift and commercial banking industries have become insolvent by billions of dol- lars. Instead of scaling back or abolishing these perverse systems, the legislative response has been to forcibly bail them out with money from taxpayers and surviving banks. At its peak in 1985, the reserve fund of the Federal Savings and Loan Corporation reached $6 billion, a small fraction of the $700 billion of deposits insured for thrift institutions. By 1989, after a cascade of thrift failures, the fund was estimated to be insolvent by as much as $300 billion ($150 billion on a "present value" basis over 30 years). Legislation passed in that year forced American taxpayers to bail out the system. As the situation deteriorated, government officials consistently underestimated the scope of the problem and the magnitude of the losses. Amidst the rubble, it was admitted that technically insolvent institutions were left open purposely by regulators, exacting greater costs on the fund. Other politicians, such as the "Keating Five" Senators, actively intervened on behalf of renegade thrift operators, allowing them to obtain special treat- ment from regulators. As recently as 1987 the reserve fund of the Federal Deposit Insurance Corporation, intended to insure over $1.6 trillion of commercial bank deposits, reached a peak of $18 billion. Even at its peak, the fund covered only 1 percent of total insured deposits and the failure of any mid-sized bank would easily deplete the fund overnight. In fact, with the failure of more than 1,000 banks in the last decade alone (more than occurred in all the years since the Great Depression), the FDIC fund was left in deficit by $7 billion at the end of 1991. As with the thrifts, government officials consistently underestimated the magnitude of the losses at banks, despite warnings from outsiders.1 Repeating earlier mistakes, regulators also per- mitted insolvent banks to remain open. The collapse of government de- posit insurance has resulted not merely from temporary phenomena, such as a recession or a few bank failures, but rather from severe structural deficiencies in the U.S. banking system; that is, from its regulation and subsidization.2 In fact, deposit insurance has promoted bank failures by promoting reckless practices and bad banking. 1 "The Banking Industry in Turmoil: A Report on the Financial Condition of the U.S.